The calculation of interest when an original overpayment is decreased on audit.

• Author: Peto, Loretta

The IRS and the courts have taken opposite positions on the calculation of interest when an original overpayment, applied to the following year's estimated tax, is decreased on a subsequent audit. The Service's position is that the interest begins on the due date of the estimated tax payment to which the overpayment is applied, regardless of whether or not any actual underpayment exists. The courts have maintained that interest does not begin until the government is actually owed tax.

In Letter Ruling (TAM) 9646001, a taxpayer had an overpayment on its 1986 return, which it filed on Sept. 15, 1987. The taxpayer elected to apply the overpayment to its 1987 tax liability, but did not specify to which installment the overpayment was being applied. A similar situation arose when the taxpayer filed its 1988 return. During the period in dispute, the taxpayer had paid all taxes due. The Service assessed interest from April 15 for both 1986 and 1988. The taxpayer claimed that the interest should begin on September l15, the date the overpayment was applied to the following year, under the use-of-money principle.

The IRS determined that the interest on the deficiency began on the due date of the estimated tax to which the overpayment was applied. The Service relied on Rev. Rul. 88-98, which stated that when an overpayment from the year is applied against the following year's estimated tax, interest on a subsequent deficiency for the first year begins on the due date of the second year's installment, but only for the amount of the deficiency not exceeding the overpayment. Interest begins on the due date of the return for the amount of the deficiency that exceeds the overpayment.

The IRS brought up an interesting issue in its discussion of unrelated overpayments. The Service mentioned Avon Products, Inc., 588 F2d 342 (2d Cir. 1978), in which the court held that under Sec. 6601, interest begins when a tax becomes both due and unpaid and that interest is not a penalty, but only a means to compensate the government for the delay in the payment of tax. Because Avon Products dealt with underpayments instead of overpayments, the IRS rejected use of the decision for the overpayment years. The Service, however, made no mention of Avon Products in its discussion of interest for the underpayment years, and the TAM was not clear on whether the taxpayer offered Avon Products as support for its position in those years.

In opposition to the TAM is The May Department...